Do Discretionary Accruals Help Distinguish between Internal Control Weaknesses and Fraud?

Mary Jane Lenard, Bing Yu, E. Anne York

Abstract

This paper extends the investigation of the effectiveness of discretionary accruals in detecting fraud and evaluating internal control weaknesses. Our sample is divided into four subsamples: healthy firms, firms that experienced internal control weaknesses, firms that committed financial reporting fraud, and firms that committed fraud by violating stock options reporting rules. We develop a logistic regression model with discretionary accruals variables and other financial variables, to identify the characteristics of firms that have internal control weaknesses and the two different types of financial statement fraud. The model is 79.1% accurate in distinguishing firms with internal control weaknesses from firms with financial reporting fraud; 71.6% accurate in distinguishing firms with internal control weaknesses from firms with options reporting; and 87.5% accurate in distinguishing firms with financial reporting fraud from firms with options reporting fraud. These models are helpful to the auditor for assessing the risk of various types of fraud.

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